When a firm is using financial leverage successfully, the percentage of increase in earnings before taxes will be greater than the percentage of increase in earnings before interest and taxes, not lower than the percentage of increase in earnings before interest and taxes.
When a firm is using financial leverage successfully, the percentage of increase in earnings before taxes will be greater than the percentage of increase in earnings before interest and taxes, not lower than the percentage of increase in earnings before interest and taxes.
When a firm is using financial leverage successfully, the percentage of increase in earnings before taxes will be greater than the percentage of increase in earnings before interest and taxes, not the same as the percentage of increase in earnings before interest and taxes.
There are two ways to calculate Degree of Financial Leverage, and this question can be answered using either one of them. (1) DFL = % Change in Net Income / % Change in EBIT. To answer this question using this formula, we plug what we know into the formula and solve for the unknown, which is % Change in Net Income, as follows: 1.5 = X / .05 Solving for X, we multiply both sides of the equation by .05: 1.5 × .05 = X X = .075 or 7.50% (2) DFL = EBIT / EBT. The best way to solve this is to make up some numbers: EBIT is $135,000; interest expense is $45,000; and EBT is $135,000 ? $45,000, which equals $90,000. Degree of Financial Leverage is $135,000 / $90,000, which is the 1.5 that it needs to be. If EBIT increases by 5%, it becomes $141,750 ($135,000 × 1.05. Interest expense is a fixed cost, so it remains $45,000. EBT is now $141,750 ? $45,000, which equals $96,750. To answer the question, we next need to find the percentage of increase in EBT. EBT now is $96,750, and formerly it was $90,000, an increase of $6,750. $6,750 / $90,000 = .075, so EBT has increased by 7.50%.
|
